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When Intermediate Capital Group announced last week it had €5.2bn in dry powder as a result of the largest direct lending fundraising globally this year, the market took notice.

Its shares rose nearly 12 per cent, their biggest intraday rise in a decade, and analysts admitted they were surprised at the size of the capital inflow.

The €27bn private debt manager had “smashed [fundraising] expectations”, said Gary Greenwood, an analyst at Shore Capital, the financial services group, while David McCann, an analyst at Numis, the UK brokerage, said he was “slightly incredulous” at the sum.

On top of €1bn from prior investor commitments, ICG raised a further €4.2bn in 2017 for its latest fund, Senior Debt Partners (SDP) III.

The London-listed group will invest this mainly in direct loans to medium-sized European companies.

The size of the deal has shone a spotlight on the growth of direct lending amid declining returns in the sector.

So-called direct lending has boomed in recent years as investment companies spotted a gap in the market created as banks, under heightened regulatory pressure to shore up their balance sheets, retreated from lending to smaller companies.

The result has been a surge in non-bank lending by asset managers and private equity groups, which can offer bespoke deals to corporate clients who would usually be too small to tap bond markets.

10.7%

Median net internal rate of return for direct lending funds of a 2010 vintage. By 2014 that had dropped to 7.9%

For investors the model offers attractive returns following years of persistently low interest rates. Money has gushed in.

Excluding the ICG record figure, direct lending fundraisings had already raised $39bn so far this year according to Preqin, the data provider, surpassing the $25.8bn raised in 2016.

But generating the highest possible returns has become more challenging. The median net internal rate of return for direct lending funds, the preferred industry measure, was 10.7 per cent for funds of a 2010 vintage, according to Preqin. By 2014 that had dropped to 7.9 per cent.

“The conditions are really good for them [but] the tricky bit is investing it and delivering the returns the clients want,” says Mr McCann.

ICG is aiming for a gross return of between 8 and 10 per cent for SDP III, a similar level to what its previous direct lending fund achieved.

“Its much harder to commoditise [private debt],” says Max Mitchell, head of direct lending at ICG, who argues that despite the boom in such funds in recent years it is still a relatively niche area. “The premium hasn’t been compressed.”

But others have expressed a concern that the explosion in credit available for companies masks deeper problems.

“Over the past 12 months, credit underwriting standards have deteriorated sharply,” says Chris Redmond, global head of credit at Willis Towers Watson, the investment consultant.

Although direct lending vehicles are acting fairly responsibly in his view, he adds that lighter loan covenants have become prevalent in the market.

On the back of those concerns, Willis Towers Watson, which advised or managed a peak of around $5bn of direct lending assets in 2015, is not allocating more money to the sector.

“We worry about the deterioration . . . we are beginning to pull back from investing new money in this space,” Mr Redmond says.

Nevertheless, analysts are generally optimistic about prospects, at least in the short to medium term.

“We are going to see a lower return environment, [but] I think there is runway,” says Ryan Flanders, head of private debt products at Preqin. “It is a good supplement to traditional fixed income. There has been a search for yield [and] this product has that fixed-income component.”

Interest from pension funds has been especially high given their traditional reliance on fixed-income products to generate steady returns. With these at record lows, many have come around, albeit gradually, to exploring alternatives.

One appeal of direct lending is that it is easy to understand, says Mr Mitchell.

“If you are the trustee of a pension, it is not super complicated. It is lending money to real companies.”

ICG has previously initiated loans to a diverse range of businesses spanning crematoria, software companies and a large property lettings agency. The average size of a direct loan they make is €140m, with the largest over €400m.

The challenge for investors now is finding fresh opportunities says Peter Bate, a director at KPMG, the professional services firm.

“People are now becoming interested in southern Europe, especially Spain and Italy, as they come out of their mire,” he says. But he adds it is incumbent on asset managers to actively hunt for opportunities, as the low-hanging fruit of some corporate lending has gone. Smaller loans are an underestimated area of opportunity, he suggests.

Expectations are riding high for ICG and SDP III. Impressive as the figures are, it needs to put the fund to work. SDP III has a management fee of 0.85 per cent and a performance fee of 20 per cent.

The fundamental drivers of direct lending — poor returns elsewhere and global banks trimming their loan books to meet stringent new capital rules — are unchanged.

Despite the boom in private debt, the caution of many institutional investors is such that many are only prepared to commit assets to such funds now, says Mr Redmond. But he adds: “The question is whether you are playing with fire a little bit if there is an economic downturn.

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